Easy for employees to take risks

24/09/2008 - 22:00

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THE next stop for the Australian All Ordinaries Index now looks likely to be 4,300 points, which will be a 61.

THE next stop for the Australian All Ordinaries Index now looks likely to be 4,300 points, which will be a 61.8 per cent retracement of the February 2003 to November 2007 bull run.

We have already witnessed what many in the industry, including George Soros and former US Federal Reserve bank governor, Alan Greenspan, are calling a one in a 100-year event. The rapid demise of a large proportion of the US financial system and the loss of many hundreds of billions of dollars in equity value, not only by US investors but a broad range of European, Asian and Middle Eastern investors, will have long-lasting economic and political ramifications.

Briefcase has previously said that, if the Australian All Ords Index were to fall below 4,700 points, then something in the global financial system would have to be seriously broken. Briefcase believes recent events on Wall Street reveal that, if the American capitalist system is not broken, it is severely damaged.

Other than an almost complete absence of regulation of the US financial system, the main reason behind this fracture is an unsustainable shift in power from business owners or shareholders to employees or managers. In effect, the animals are now running the farm and, in truth, the farmer is not entirely blameless for sitting nonchalantly aside while this power shift happened.

Briefcase believes there is no job that an employee can do and no task so large that any employee can undertake for which shareholders should have to pay a salary and bonus of $40 million per annum. This type of return is surely reserved for high-risk equity holders, those who support a business with their hard-earned savings and then contribute sweat equity by working for discounted wages while a business is established.

What does an employee risk for his or her salary? The answer is nothing but a job. All care but no responsibility.

The people who ran Bear Stearns into the ground can go off and get another job somewhere, with little loss, while in many cases the investors who backed the company have lost their entire savings pool. During the past 50 years, the US has led the world's markets and established the operating and financing trends that now drive most markets around the world. The US financial disease will be cured when investors realise that only those with large amounts of equity at risk in a business deserve the sort of financial returns we have recently seen bestowed on the hired help.

In the US, they call wages 'compensation'. A person is compensated for taking a job, as if they had to be dragged away from lying on a beach or some other meaningful task to take up the job for which they expect to be compensated. Only the Americans can screw up the language so badly. The big cheese at Lehman Brothers took home a cool $US40 million last year for running that business into the ground on behalf of its shareholders. Shortly before Bond Corporation went belly up in the early 1990s, Alan Bond argued that he had to pay his henchmen the incredible sum (at the time) of $5 million a year because of the good job they were doing for shareholders. If he'd insisted they divert that money into shares in the company, perhaps there would have been a better outcome for all concerned.

The sort of compensation packages recently used at the silly end of the market include those used by most financial intermediaries, including Lehman Brothers and Enron Corporation, before they went belly up. These types of wage packages rely on a high level of bonus payment - bonuses based on business written, whether it is good business or bad, so long as there is an upfront fee earned. So you get smart guys writing any sort of business, including selling sub-prime loans to folks on welfare, just to top up their bonus package. Clearly, this sort of wage or bonus package works against the interests of equity holders, so that the animals are actually destroying the value of the farm. Indeed, what has happened is that the hired help has gained too much control of the farm and they don't have skin in the game.

Briefcase believes it is time for a new model for paying staff, which delivers a reasonable wage to management, but offers potential for a large increase in personal wealth, based on an employee's willingness to take up equity in the business in which they work. If they don't want to take up equity, they take a salary. If they take up equity, even with shareholders assistance, via options or the like, they gain an ability to create serious personal wealth as they create wealth for other equity holders (our farmers in the previous analogy).

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Nexus is a strong growth company with strong technical and corporate management skills. Its operations at the Crux condensate project are going to have a big impact on the Western Australian economy during the next three years. Briefcase estimates a base, risk adjusted target value of $3.55 per share for the company with upside to about $6 per share.

Nexus Energy has pulled off an excellent deal to fund its interests at the Crux condensate project and nearby exploration acreage. The company has sold down 25 per cent of the Crux project in AC-P-23, to leave it with a more manageable 60 per cent of this $1.2 billion project, and sold 20 per cent of the surrounding AC-P-41, leaving it with a 30 per cent ongoing interest in the exploration potential. The as yet un-named new 25 per cent participant should logically be Shell, which already owns the Crux gas and is a 50 per cent partner in AC-P-41, but some in the market think that the new money comes from Japan.

This $US275 million deal effectively underpins Briefcase's valuation for Crux alone at around $1.20 per share to Nexus, while funding of an additional $US34 million for exploration, supports a strong value for surrounding prospects. The deal leaves Nexus with net cash plus Anzon Energy shares valued at a total of about $310 million, which importantly in the current market conditions should be sufficient equity to support field development at Crux and its Longtom gas project in the Gippsland Basin.

Meanwhile, at Longtom, development drilling work has established gas deliverability of over 140 Tj per day, which is twice the initial contracted volume of 25 Pj pa (70 Tj pa). Nexus still has considerable capital spending to complete at Longtom, on subsea equipment and laying of pipelines connecting the field to the Patricia-Baleen field. This work during the December quarter could amount to an additional $140 million, prior to first cash flow in Q3 2009, so cash will remain tight at Nexus' treasury.

The Ocean Epoch drilling rig has been contracted to drill the Shell-operated Libra-1 prospect in the Browse Basin permit AC-P-41, starting early October. This 33-day well will test a possible southern extension of the Crux field into AC-P-41. Nexus estimates a most-likely gross recoverable resource of 500 billion cubic feet (Bcf) of gas plus 19 million barrels (mmbbl) of condensate that Libra. Any exploration success would also improve prospects for the 35mmbbl plus 1,000 Bcf Auriga-1 and the 28mmbbl plus 820 Bcf Caelum-1 prospects in AC-P-23, while the potential 280 Bcf gas plus 11mmbbl condensate Octans-1, SW of Crux in AC-P-41 is another well candidate for a total 3-well program, partially funded for Nexus by its new partner.

Ultimately Nexus, Shell and its new partner will most likely evaluate a floating LNG facility for Crux, which might come alongside its condensate stripping plant by 2018.

Nexus has a base value of $2 per share for cash and known hydrocarbon assets, plus risked exploration upside of $1.55, which includes a risked value for its interest in Echuca Shoals.

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- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

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